Small Cap Value Report (27 Dec) - IOF, CSFG, CNC

Good morning! I trust everyone is fully charged up with Christmas cheer. The Santa Claus rally is still in full swing, although I can't help feeling that the market will jump at the slightest chance to have a proper sell-off in the New Year. We haven't had a proper correction for a long time now, and there are considerable areas of over-valuation now in my opinion, especially growth stocks, some of which are really on bonkers valuations.

Remember that a classic sign of a bubble is when people start detaching from conventional valuation methods, and just buy things because they keep going up. I'm not saying that kind of euphoria is evident in the entire market, but it's very clear that many growth stocks are now priced to perfection. So people speculating in that area need to be mindful that there is always a risk that such stocks will, sooner or later, come back down to earth with a bump. People who were not in the market in 1998-2002 should look back at the charts of trendy growth stocks back then. People who were in the market in 1998-2002 should refresh your memories as to what happened to your own portfolio at the time - the financial memory is about 15 years they reckon, so the timing is perfect for a re-run of the TMT (technology, media amp; telecoms) mania that we saw in the late '90s.

Mind you, these bubbles can keep going far longer than anyone imagines, as indeed happened 15 years ago. The bubble finally burst in Mar 2000, when it had sucked in vast amounts of money into many essentially worthless (or worth very little) growth companies, and left a trail of destruction which saw numerous shares drop 90%+. Many even went to 99% losses. I'm not saying we are in the same situation yet, but we're certainly in the early stages of the "euphoria" part of a bull market, in my view.

Whether to take cover, or to make hay when the sun shines? I think it's a good time to find the most credible, and reasonably priced growth stocks, and make some money on them. But personally I'm not chasing story stocks with negligible turnover but gt;£100m market caps - experience has shown that the vast majority of such hyped up story stocks fail to deliver.

Remember that I'm writing from a Value/GARP perspective, so it's entirely possible that some readers may disagree, and think that this is a time to be ultra-bullish on growth stocks. That's fine, whatever floats your boat. I'm sticking to the strategy that works best over the long term, whilst being a bit more flexible (i.e. holding things to higher valuations than I would have in the past) in recognition of bullish market conditions.

Advertisement

The other thing to be terribly careful about is gearing. I've written extensively about the major problems I experienced in 2007-8 when my personal portfolio was highly geared, and concentrated in large positions in small, illiquid stocks. That was a disastrous combination, which taught me a very big lesson, the hard way. So it's very important to remember how dangerous gearing can be, and in conditions like this bull market, people who throw caution to the wind make the most money in the short term. However, they will also crash the hardest when it all goes wrong.

Or even when individual stocks crash. It's crazy the way some people take large leveraged bets on highly speculative stocks. That's just an accident waiting to happen. We've seen that with the high volatility of stocks like Iofina (LON:IOF), a favourite of Spread Betting clients apparently. When the price suddenly plunges, everyone is stopped out, and if their position size is too large it can lead to a large chunk (or even all!) of their equity being wiped out. Why take the risk? In my view Spread Bets only make sense for more stable stocks, and even then only if gearing is carefully controlled (or not used at all - there is no obligation to gear up in a SB a/c). It's also vital to diversify properly in a SB a/c. Overall I would say that Spread Betting is far too risky for anyone but the most experienced investors, who also possess strong self control.

However, it can work if you establish a strict set of rules covering maximum gearing (which should never be more than 2 times equity, in my opinion), diversification, maximum position size, restrictions on illiquid stocks, etc. Again, not for the feint-hearted, or the inexperienced.

A roaring bull market like this can be indiscriminate, in that shares in genuinely ground-breaking companies like Twitter can detach from reality in terms of valuation, but in that case Twitter is unique, and there are many ways in which it will be able to generate revenue amp; profit in future, that have not even been tapped yet. So I completely "get" Twitter, both as a user, and as an investment, where current trading really is totally irrelevant to the valuation.

However, the same cannot be said for the numerous other supposedly high growth, loss-making companies that are also being dragged up in value by speculative forces right now. I think many of these things are accidents waiting to happen. Just look at how shares in Perform (LON:PER) have lost about two thirds of their value this year, with £1.2bn being wiped off its market cap, once the market realised that the growth assumptions were wildly optimistic.

Advertisement

Even if we do see continued bullish market conditions, I expect to regularly see high growth company shares instantly halve in value, when their results or trading statements are released, when investors suddenly realise that the speculative frenzy that took the shares up, is not justified in terms of performance or outlook once the rose-tinted spectacles are taken off.

Anyway, turning to results today, as you would expect there are very few - hence why I take the opportunity on days like this to have a general chat about market conditions amp; strategy. This is intended as a discussion starter, so please do add your thoughts in the comments section below.

Shares in CSF (LON:CSFG) have dived 30% this morning to 5.5p, so they are now down over 90% in the last 3 years, a disastrous performance. It's a Malaysian data centre company, Listed on AIM. This is a perfect example of why I don't touch overseas companies which List on AIM. The figures look an absolute car crash, with heavy losses from onerous leases, and doubtful debts.

It's worth taking a look at the audit report with the results published today, as Deloittes have taken the extremely unusual step of qualifying the audit report, including the following statements;

Qualified conclusion

Advertisement

Whilst we concur that the basis of preparation remains appropriate, in our opinion the company has made inadequate disclosure of the material uncertainty in relation to going concern. This uncertainty arises from the risk of delay to forecast significant contractual receipts which the company is reliant upon in order to continue as a going concern.

We disagree with the directors who do not deem the uncertainties described above to be material. In our opinion, the interim financial information requires disclosure of this matter as a material uncertainty relating to the ability of the company to continue as a going concern and to realise its assets and discharge its liabilities in the normal course of business.

That's certainly one of the most stark warnings I can remember seeing from any auditor about a Listed company's financial position. So anyone holding shares here will not be able to say that they weren't warned, if the company does go bust.

It's good to see an auditor take a strong stance, there needs to be much more of this.

The whole system of auditing is fundamentally flawed, because the external auditors are supposed to be independent, yet are appointed by, and their remuneration determined by, the Directors of the company that they are meant to be independently auditing! This is a ridiculous situation, as there is a gigantic conflict of interest.

Advertisement

The system needs to be changed so that the auditor is appointed by a committee of shareholders, completely separate from the Directors of the company itself. After all, the auditors are supposed to report to shareholders, so why are they not appointed by shareholders? This would be such a quick fix for many of the things that are wrong with corporate Britain - at a stroke this change would create powerful watchdogs with real teeth. I can feel a letter to Vince Cable coming on.

Concurrent Technologies (LON:CNC) is a small (£26m market cap at 37.5p per share) niche electronics company that has somehow slipped through the net here over the last year, in that I don't seem to have reviewed it before in my morning reports.

Their shares have performed badly this year, and are now at a 12 month low, which has already got me interested. It may be unfashionable at the moment, but I like buying shares when they are low, providing there are good reasons to expect them to recover.

The trading update from CNC today says that results for the year ending 31 Dec 2013 are expected to be "broadly in line with market expectations". So to translate that from PR speak into plain English, results are going to be slightly below market expectations.

Looking at the StockReport page for Concurrent, turnover has been fairly static at between £12-13m p.a. in recent years, with a fairly reliable £2-3m profit made each year - a very healthy profit margin as a percentage of sales. Also it has net cash on the Balance Sheet, and has reliably paid divis in recent years. So my type of company on the face of it, although the lack of growth makes it less interesting.

Advertisement

The trouble is, and this is a problem with a lot of small caps, they refer to market expectations in the trading update today, but I can't find any broker forecasts for the company, on either of the two websites I use for broker forecasts! So really what's the point in telling the market that they are trading broadly in line, with a forecast that most of us haven't got access to?!

So I've had a quick look at their last set of interim results to 30 Jun 2013, and they're not good. Operating profit fell from just over £1m last H1, to only £339k operating profit this H1. The Balance Sheet is strong however, so that helps.

The problem seems to be Government licensing for exports, and this is referred to again in today's statement, with hopes for an improved licensing regime in the future. Perhaps that is why the shares have not fallen as much as I would have expected given the poor interims?

My conclusion (from the most cursory initial review) is that this is one to put on the watch list, as they don't look cheap based on current performance. However, if there is a recovery in trading to be had, then I might look again. The divis are nice, and the yield is almost 4.7%, but experience shows that chasing yield at a company where trading is deteriorating, can often be a mistake, as a dividend that is not well covered by earnings (and/or cash in the Bank) can end up being cancelled in future. It's a company's ability to pay dividends that is really more important than the actual level of dividend payments at the moment.

I'll sign off for today, and the week.

Advertisement

As regards next week, my intention is to produce reports every weekday apart from Weds, which is a Bank Holiday for new year's day. Remember that Tuesday is a half day on the markets, but I'll still do a report, if there's enough interesting stuff to comment on.

Regards, Paul.

(of the companies mentioned today, Paul has no long or short positions)